Asia’s central banks have loosened monetary conditions to counter the disinflation caused by weak growth and structural changes. But, like central banks elsewhere, they are also increasingly involved in supervising and regulating the financial sector, with greater utilisation of macroprudential measures.
Of Asia’s 15 main central banks, 13 list price stability as an objective and 7 have explicit numerical inflation targets. The Bank of Japan last year became the latest to adopt inflation targeting.
Five Asian central banks include exchange-rate stability as a policy objective. The importance of exchange-rate swings was demonstrated during the 1997 Asian financial crisis by mismatches in balance sheets, the effects on inflation in resource-scarce economies, and the sensitivity of business sentiment in trade-dependent economies.
Most Asian central banks participated in currency markets to tame higher capital flow volatility following the 2008 global financial crisis, mainly through market interventions, though other methods range from verbal statements to easing rules for exporters.
The world’s central banks face new challenges in pursuing financial stability
However, there are costs in targeting currency stability: reserves can rise to undesirable levels when a central bank tries to prevent excessive currency appreciation. Over the past decade, Asian currency reserves have risen as a share of GDP. This expands a central bank’s balance sheet and increases local money supply, ultimately spurring inflation.
Central banks may act to withdraw liquidity, usually through forward operations. However, such sterilisation measures can threaten financial stability. Providing the market with relatively safe and low-yielding assets may incentivise the private sector to take on higher risks for higher returns, fuelling credit growth and potentially inflating asset bubbles.
So even while sterilising capital inflows, central banks have had to resort to other tools, including macroprudential rules, to tame financial froth.
Asian economies received large and increasingly volatile capital flows after 2008, reflecting increased global liquidity from the quantitative easing programmes of central banks in the US, eurozone, UK and Japan. The spillover in Asia is asset bubbles, credit-intensive growth and volatility.
Central banks in Asia have responded with macroprudential policy measures – based on housing; credit and reserve requirements; capital, provisioning and liquidity; plus capital flow management.
Although financial stability is rarely stated as an explicit policy objective for Asian central banks, most have taken steps to mitigate systemic risks – partly because the 1997 Asian financial crisis demonstrated the potential damage a reversal in capital flows can inflict. So short-term external debt has come down as a share of currency reserves, bank loan-to-deposit ratios are lower and current accounts are generally stronger than two decades ago.
Even so, the world’s central banks face new challenges in pursuing financial stability. Policy tools are still being developed in response to experience. But with no single quantifiable objective for financial stability, unlike inflation targeting or exchange-rate stability, it is difficult to assess success.
All this points to an expanding scope of central bank activity. Inflation targeting may be complemented with aims such as preventing excessive risk-taking and financial imbalances. This entails risks, including the dilution of inflation targeting as a policy goal. This may not seem a big danger now, but price pressures could change quickly if growth re-accelerates.
This article was first published on 6 June 2014.